Schaeffer's Outside the Box Blog

Heady VXX Times

by 11/6/2012 7:29 AM
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Way back when, we used to joke about something called the "Rio Spread." The idea was that you sell a lot of straddles and strangles in something, and then go take the premiums you generated and use them to pay for a trip to Rio. And then just stay there if the spread blows up in your face.

This name disregards the fact that you don't actually get a check you can spend for the premiums you generate. There was a hidden truth within the joke, though, as the concept of selling options premiums involves putting your finger over it (metaphorically) and hoping for the best. And the "best" is that you won't have to trade much to defend the position, time will pass, and the options you sold will decay.

I bring that up because if I had the foresight to put on a "Sandy" spread before New Jersey went dark, it would have worked like a charm. The SPDR S&P 500 ETF Trust (SPY) closed at $141.35 on Oct. 26, and it opened around $141.25 yesterday. That's 10 days of time decay with nary the opportunity to hedge it. Of course, it's not quite that simple, as time decay calculations assume a fixed implied volatility, and the CBOE Market Volatility Index (VIX) did lift a bit over the past 10 days. It closed on Oct. 26 at $17.81 and finished at $18.42 on Monday.

So -- pretty "free" money there. But one caveat: please don't take this as a trade recommendation. If you hear a storm is coming, don't just sell strangles and go into a bunker. Any trade works in hindsight, if you selectively choose your starting and end points.

There is one really interesting development over the last 10 days, though. The VIX curve has flattened in the nearer months. November futures trade near 18 and December futures trade near 18.5. That half-point difference is about as low as we've seen a one-month spread since, well … forever. And both cycles sit near parity to VIX itself.

Those high-fives you see come from iPath S&P 500 VIX Short-Term Futures (VXX) owners. With little slope and no premium to cash, that headwind the VXX usually faces has disappeared for now. And it may stay away for the next couple of weeks at least. December VIX tends to trade on the cheap side. Remember that VIX futures snapshot the VIX on the day the future expires. And the December future expires on Dec. 19, which means the actual VIX that day will incorporate trading over the entire late-December, slow-holiday-trading season.

But enjoy it while it lasts. The usual 99 contango problems figure to return again once November VIX expires and December VIX becomes the near month. That's because the December/January spread has the reverse dynamic. The VXX will have to roll out of depressed December Futures and into relatively high January futures. The December/January spread is already at 1.50.

So the VXX might remain relatively stable versus the VIX for the next couple of weeks, but all things being equal, the Regularly Scheduled Ugliness should resume just in time for Thanksgiving.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.

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